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Choosing Your Path for Success
When setting goals, we believe it’s more important to focus on the big ideas to increase your chances for success rather than being bogged down by details.
For investment goals, whether it’s dynamic, strategic or some other approach, we believe asset allocation is key to determining how your portfolio will perform.
Whichever asset allocation approach you choose, your outcome will likely be improved by sticking with it.
To get to where we want to be in life, we must set goals. Everyone has goals they want to achieve, whether it’s getting to work on time, spending more quality time with family, or losing ten pounds before summer. At a high level, the goals are often quite similar. However, the approach each person takes to achieve these goals can vary significantly. For example, if your goal is to improve your physical fitness level, you know you must engage in some type of exercise on a consistent basis. Whether this exercise involves lifting weights at the gym or running outdoors doesn’t matter as much—you’re likely to improve your fitness level either way, so long as you commit to doing it routinely.
The same can be said for setting and achieving financial goals. For many people, financial goals include purchasing a new home, putting children through college, or retiring comfortably. To meet these goals, you need a financial plan. And, like other goals you may set for yourself and the plans you make to accomplish them, it’s more important to get the big things right than fret about the details if you want to increase your chances of success.
The Importance of Asset Allocation
In portfolio construction, your asset allocation is the number one determinant of how your portfolio is likely to perform over time. In fact, studies have found that asset allocation can account for as much as 93.6% of the variation of an investment portfolio’s return
Put differently, if the mix of assets in your portfolio corresponds appropriately with your goals, the specific funds and securities you hold won’t impact your outcome significantly over the long run. Therefore, the most important component of your long-term investment plan is determining the best asset allocation approach given your financial objectives and circumstances.
Broadly speaking, the two most common approaches to asset allocation are strategic asset allocation and dynamic asset allocation.
Bowling vs. Curling (And How These Two Sports Relate to Asset Allocation)
The best way to articulate the nuances between strategic and dynamic asset allocation is to compare each approach to two sports you may already be familiar with—bowling and curling.
In bowling, each competitor rolls their bowling ball down the lane with the goal of knocking down as many pins as they can. Once the ball is set in motion, its trajectory is determined, and there’s no possibility for course correction. The bowler must simply wait for the outcome. This can be likened to strategic asset allocation—the trajectory is determined at the beginning of the process, and the investor’s portfolio remains static regardless of the prevailing market environment. The outcome is determined by when the investor needs access to his or her money and the portfolio balance at that time.
In curling, each player pushes a stone down a lane with the goal of hitting a target. However, unlike bowling, players can course correct by making many small adjustments along the way instead of one big movement at the outset. This is similar to dynamic asset allocation Although an initial trajectory is set, adjustments can be made along the way to respond to changes in the environment and help the investor hit their target. The target, in this case, is a clearly defined financial obligation at a specific future date.
More formally, strategic and dynamic asset allocation can be defined as follows:
Strategic Asset Allocation:
This approach allows the investor to select a fixed proportion of stocks, bonds, and/or other asset classes and hold the selected proportions indefinitely. In most cases, the portfolio is rebalanced to its targets when performance differences cause the initial proportions to deviate meaningfully.
Dynamic Asset Allocation:
This approach allows the investor to adjust the mix of asset classes within their portfolio over time based on relative attractiveness and return potential considering prevailing market and economic conditions.
Choosing the Right Approach
You may not know immediately which approach makes the most sense for you given your financial goals—and, perhaps more importantly, your attitude towards investing. Just as you have several viable methods available to you if your goal is to become more physically fit, you’re likely to get in better shape financially no matter which asset allocation approach you choose. The key is selecting the approach that you’re most likely to stick with over time.
To help you decide whether strategic or dynamic asset allocation is more suitable for your long-term investment plan, you can ask yourself some revealing questions about your attitude towards investing from a practical, behavioral, and theoretical perspective:
Do I prioritize simplicity?
If you tend to favor strategies that are straightforward and easy to understand, strategic asset allocation may be more appropriate. Although both approaches have their merits, dynamic asset allocation is more complex with many moving parts.
Can I clearly articulate my financial goals?
If you know exactly what your future cash flow needs are—for example, purchasing a new home or paying college tuition—and when those obligations will occur, a dynamic asset allocation approach may increase the likelihood of you meeting those goals. On the other hand, if you are simply accumulating excess capital that may or may not be used in the next few years, you may be better served with a strategic asset allocation approach.
Will I be upset if my portfolio’s performance doesn’t match the performance of industry benchmarks?
If you watch the news, you know it’s impossible to avoid hearing about how the S&P 500 or Dow Jones Industrial Average performed on any given day. While these indexes are limited in scope compared to a diversified investment portfolio (and therefore not always the best benchmarks for success), it’s common for investors to become uneasy when their portfolios are underperforming the broad market. If you can relate to this feeling, you may be better suited for strategic asset allocation.
Can I tolerate periods of disappointing performance?
While all investment strategies will elicit feelings of disappointment from time to time, you should never be so uncomfortable that you’re tempted to abandon your investment plan altogether. If you know that you can’t tolerate significant losses in your investment portfolio, even temporarily, selecting a strategic asset allocation model with a static percentage in high quality bonds will likely help you stay the course over time.
Do I believe it’s possible to determine when certain assets are positioned to perform better than others?
If yes, then a dynamic asset allocation strategy is probably the right choice. Those who follow this approach tend to believe that it’s possible—and reasonable—to determine a fair price to pay for an asset, and that this price is indicative of the asset’s future performance. Conversely, if you believe asset prices and return are somewhat random, then you’re probably more philosophically aligned with those who follow a strategic asset allocation approach.
How do I define risk?
Do you think risk is measured solely by a portfolio’s recent performance characteristics, or do you define risk as not meeting your future cash flow needs? The corollary to this question is how you define success. If your goal is to consistently outperform a broad market index, then an asset allocation approach that is geared towards outpacing its respective index benchmark is likely right for you (in this case, strategic asset allocation). However, if you define success as meeting your future financial goals, dynamic asset allocation is probably more appropriate.
Depending on how you answered each of these questions, it may now be readily apparent which approach is best for you. The more specific you can be in defining your goals, the better off you’ll be in finding the most effective approach for achieving them.
Getting the right approach for you is important because asset allocation can only do its job effectively if you’re able to stick with it through bad and good periods. If you’re still unsure which strategy is right for you, talk to your financial advisor, who can help you find the most likely path to success.
"Determinants of Portfolio Performance", Gary P. Brinson, Randolph Hood, and Gilbert Beebower,
Financial Analysts Journal
Disclaimer: Ronald Blue Trust obtains historical and other information from a wide variety of publicly available sources. The information and material provided is for informational purposes only and is intended to be educational in nature. We have taken reasonable care and precaution to ensure that the information is fair and accurate, or has been compiled from sources believed to be reliable. Nevertheless, we do not make any representations or warranty, express or implied, as to the accuracy, completeness, or fitness for any purpose or use of the information. The information may not in all cases be current and it is subject to continuous
change. Accordingly, you should not rely on any of the information as authoritative or a substitute for the exercise of your own skill and judgment in making any investment or other decision. We recommend that individuals consult with a professional advisor familiar with their particular situation for advice concerning specific investments, accounting, tax, and legal matters or other matters before taking any action. We shall not be liable for any direct, indirect, or consequential loss arising from any use of or reliance on the information contained here. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Investing involves risk and the value of your investment will fluctuate over time and you may gain or lose money. Past performance of any security, sector or investment style is not necessarily indicative of future results.